Exchange Rates and Exchange: How Money Affects Trade

STUDENT'S VERSION

INTRODUCTION

In June 1998, the U.S. stepped into the foreign currency market, using billions of U.S. dollars to buy Japanese yen in an attempt to stabilize its value. Mexico faced a currency crisis in 1994. Argentina faced such a crisis in 2002. Why should we care about currency values of other nations?

How do currency values affect us, the demand for the products we produce, and the prices of the products we buy?

TASK

This lesson examines the role that money plays in the global economy. You will learn how currency values are set by supply and demand, and how changes in the value of currency affect international trade. You will then have the opportunity to find the value of the Brazilian Real in 2000 and 2002, determine whether the currency has appreciated or depreciated, and predict the effects on imports and exports.

PROCESS

When people in one country demand products from firms in another country, they must enter into another market first, to buy that nation’s currency. For example, if you were employed as the merchandise buyer for a retail consumer electronics firm and wanted to buy Sony CD players to sell to your customers, you would not simply send a check to Sony in the amount of American dollars. Firms want to deal in their own currencies. As a result, you would have to go into the foreign exchange market to buy yen, which you could then use to pay Sony for the CD players.

In the same way that supply and demand for products shift to change the prices of those products, the constant shifts in the supply and demand for foreign currency result in changing prices of currency. As a result, the “price” of money changes as demand for foreign currencies changes. This “price” of foreign currency, in terms of U.S. currency, is known as the foreign exchange rate. It simply tells you how many American dollars it will cost you to purchase a unit of foreign currency. This “floating” foreign exchange rate changes daily with the international supply and demand for currency.

A number of factors can increase demand for a foreign currency. If the other nation’s products sell at a lower price than domestic products, consumers will increase their demand for imports. If domestic incomes rise or domestic inflation rates are higher than those in other nations, demand for imports will rise, as well. In capital markets, if another nation’s interest rate (return on investment) is higher than the domestic interest rate, some people will choose to invest in the other nation’s securities. When consumers import more products from a country or invest in that country’s securities, their demand for that currency increases. This increase in demand pushes the price of the currency higher, so their currency appreciates (rises in value).

Because consumers use U.S. dollars to buy the foreign currency, when the demand for foreign currency increases, the international supply of U.S. dollars increases proportionately. As the supply of dollars increases, the “price” of U.S. dollars falls, causing the dollar to depreciate (fall in value).

In the international market today, the supply and demand for currencies and the resulting relative values of currencies can affect the demand for imports and exports. For example, if we have a strong dollar, the dollar is very valuable compared to other currencies; other currencies appear very inexpensive to us. Because we can buy the currency more cheaply, the prices of the country’s products appear lower to us. And at lower prices, quantity demanded rises. So when the U.S. has a strong dollar, we buy more imports from foreign countries. This helps U.S. importers, such as electronics outlets, grocery stores, and gas stations, because when they can buy goods at a lower cost, they can offer those goods to their customers at lower prices, increasing the quantity demanded for their products and potentially increasing their profits.

An important negative effect of the strong dollar, however, exists for American exporters. When we have a strong dollar, buyers from other countries see our currency as being very expensive; they must give up more of their currency to buy dollars. As a result, the prices of our products appear more expensive to them. Therefore, the quantity demanded of our exports falls. This harms U.S. exporters, such as computer companies, auto manufacturers, and farmers, because they must lower their prices to try to attract demand for their products, resulting in lower profits and possibly forcing some firms out of business completely. The resulting impact of a strong dollar is a trade deficit. Imports rise, while exports fall.

The interesting thing about this entire phenomenon of changing exchange rates is that they can be self-correcting over time. For example, when we have a strong dollar, we demand more pesos to buy more Mexican products. But the very act of demanding more pesos causes the peso to appreciate, so Mexican imports appear to be more and more expensive over time. At the same time, the supply of U.S. dollars in the international market is growing, so their value falls as the dollar depreciates. Over time, imports are not as attractive, but our exports become more attractive to other countries, because their currency has become stronger. At that point, the U.S. would have a weak dollar--a condition, in which U.S. dollars are not very valuable compared to other currencies. Such a situation helps U.S. exporters, but hurts U.S. importers. This rise in exports and fall in imports results in a trade surplus. But over time, the situation can again reverse itself, as the increased foreign demand for U.S. exports forces up the prices of American goods internationally, so the quantity demanded by foreign countries again begins to fall.

In the cycle of international trade, changes in relative incomes, inflation rates, product prices, and interest rates can affect the international value of currencies. And at the same time, changes in the international value of currencies can affect the demand for products and securities in the international marketplace.

CONCLUSION

As supply and demand for currencies change, the values of those currencies change. When the U.S. dollar is strong, imports seem less expensive, leading to increased demand for imported products and the currency needed to purchase them. In addition, when interest rates in another nation are higher than those in the U.S., demand for the foreign currency rises, as people buy the currency in order to invest in the other nation’s securities. At the same time, a stronger dollar decreases exports, because they appear more expensive to foreign consumers. Therefore, a trade deficit develops as the result of a strong dollar. The opposite effects result from a weak U.S. dollar. While importers prefer a strong dollar, exporters prefer a weak dollar.

The differences in currency values can affect our ability to buy imports or sell exports, affecting our standard of living. Therefore, the effects of currency crises in other nations are not limited to those nations -- they can affect our economy and our lives in important ways.